Friday, 2 September 2011

Borrow!

It's nice to see both Paul Krugman and Stephen Landsburg agreeing with me, though they surely didn't see my post.

Back in April, I'd argued against the Green Party's push for a tax hike to pay for the earthquake. The New Zealand Greens wanted, and still want, a current earthquake levy on higher incomes to cover some of the rebuilding; they argued vehemently against cuts elsewhere. I made the usual standard argument from standard theory that equating marginal returns from government spending across different areas meant we had to cut spending on some non-earthquake areas. And, we'd want to take on debt.

So even if you reckoned the ex ante mix of spending and taxation was optimal, the best response to the quake seems likely to involve cuts to non-quake programmes, increased debt, and future tax increases. If you figure, like the Greens, that the ex ante mix had way too little government spending, you'd push for smaller cuts to non-quake spending and larger future tax increases; it's beyond me why they're averse to debt to fund a massive capital reconstruction project. If you figure, like National, that the ex ante mix had too much government spending, you'll bring forward some of the cuts that you'd already had in mind while raising debt and pushing back future plans for tax reduction. If you reckoned, like me, that a reasonable proportion of government spending was of negative value, the case for cutting that spending has gotten stronger.

It's hard to avoid that the optimal arrangement involves some cuts to relatively low value government programs, even if you think those programs are of positive value.

Now suppose a disaster strikes. What this does is raise the marginal benefit of spending on disaster relief. The appropriate response is to move all the marginals to get them in line: spend less on everything else, and also raise more in taxes. So even there it shouldn’t be all offsetting spending cuts.

But wait: even more important, the government can borrow (or, in principle, lend, if it pays off all its debt). So it should balance its budget in present discounted value terms, not year by year. This means that the tradeoffs should include future spending and taxes as well as this year’s spending and taxes. And a natural disaster, like a war, is a temporary event; it should be met largely through higher taxes and lower spending in the future rather than right away, which is another way of saying that it should be paid for in large part by a temporary increase in the deficit.

This isn’t some novel idea, by the way — it’s the standard theory of public finance during war, going all the way back to Ricardo. And the logic of wartime finance applies equally to natural disasters.

To get a little wonkier, there are actually two separate points here. First there’s the point that comes from public finance: Unless you believe that everything is perfect to begin with, the Ricardian argument fails, leaving you with no reason to believe that the cost of new spending should be spread widely. Instead, you should start by cutting back on your least wise activities. Cantor and Krugman probably have some legitimate disagreement about what those least wise activities are, but neither of them has any reason that I know of to believe that all activities are currently equally wise at the margin.

And so Krugman puts out the case that the Greens here should be making, and Landsburg adds in that if we were spending too much on dumb things to start with, it makes even more sense to stop doing that when we have to pay for a natural disaster.

So the consensus across me, Krugman and Landsburg seems to be that it's absolutely bonkers to try and pay for something like a massive earthquake out of a current big tax increase. Some mix of debt and reallocation of current spending ought to be used, with tax increases in future.